Reserve Bank announces changes to FX management

Release date

12 July 2007

The Reserve Bank today announced
changes to its financing and management of New Zealand's foreign currency
reserves.

The moves arise from a review of the Bank's balance sheet, announced in
its Statement of Intent in June 2006. The review was aimed at enabling
the Bank to manage its balance sheet to best meet monetary policy, currency,
liquidity management and foreign reserves requirements.

Reserve Bank Governor Alan Bollard said that for the last 20 years, the
Bank's foreign currency assets have been fully matched by foreign currency
liabilities.

"That was an unusual approach by international standards and we are now
moving in the direction of a more conventional approach," Dr Bollard said.

In the future we will hold some portion of our foreign reserves on an
unhedged basis – an "open FX" position. This means that part
of the foreign reserves portfolio will be funded in New Zealand dollars rather
than in foreign currencies."

Dr Bollard said that the main reason for this new approach to foreign
exchange (FX) management is to give the Bank a more effective means of
responding to crisis situations involving sharp falls in the NZ dollar.

"In crisis situations it is of paramount importance that the Bank
retains access to foreign currency reserves. With a portion of our reserves no
longer borrowed from abroad, but funded internally, we will become less
dependent on international capital markets in times of crisis.

"Also, the use of unhedged reserves in this situation will be less
costly and give rise to less additional risk than would be the case using hedged
reserves. Unhedged foreign reserves provide a more effective form of insurance
against a currency crisis."

The Bank's guidelines for operating in the foreign exchange market have
also been modified. Overt intervention intended to affect the exchange rate
directly may still occur. In addition, the Bank will be able to more gradually
accumulate or reduce its foreign exchange position when the exchange rate is at
extreme levels and unjustified by medium-term economic fundamentals.

Dr Bollard said that the Bank's more passive FX transactions will not
necessarily be expected to directly affect the exchange rate.

"However, such transactions will allow the Bank to give concrete
signals regarding the extent to which the exchange rate is seen as over- or
under-valued. That may indirectly affect the exchange rate by discouraging
speculators from pushing the currency to extreme levels."

Because the interest rates on the Bank's New Zealand dollar borrowings
are higher than on foreign currency borrowing, the annual cost of holding
foreign reserves is expected to increase somewhat with the change in approach.

The increased open FX position on the Bank's balance sheet is also
expected to result in greater variability in the Bank's net income, as a
result of foreign exchange gains and losses. However, the Bank's foreign
exchange positions could be expected to be profitable on average over the medium
term.

The Bank has been using and will continue to use its FX market operations to
lift the level of its unhedged reserves towards a new long-run average level.
The Bank publishes its open foreign exchange position monthly on its website,
with a lag of one month.

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